Saturday, June 5, 2010

Monetary Policy

Monetary Policy:
There are mainly two important instruments with which objectives of macroeconomic policy can be achieved. It is worth noting that it is the central bank of a country which formulates and implements the monetary policy in a country. In some countries, the central bank works on behalf of the government and acts according to its directions and broad guidelines. However, in some countries the central bank enjoys an independent status and pursues its independent policy. Monetary policy is concerned with changing the supply of money stock and rate of interest for the purpose of stabilizing the economy at full-employment or potential output level by influencing the level of aggregate demand. More specifically, at times of recession monetary policy involves the adoption of some monetary tools which tend the increase the money supply and lower interest rates so as to stimulate aggregate demand in the economy. On the other hand, at times of inflation, monetary policy seeks to contract the aggregate spending by tightening the money supply or raising the rate of interest.

Objectives of Monetary Policy:

In the context of developing countries like Bangladesh the following three are the important objectives of monetary policy:

· To ensure economic stability at full-employment or potential level of output.

· To achieve price stability by controlling inflation and deflation.

· To promote and encourage economic growth in the economy.

Tools of Monetary Policy:

The tools or instruments of monetary policy are of two types – quantitative and qualitative.

Quantitative Tools:

· Bank rate policy: The bank rate in the minimum lending rate of the central bank at which it rediscounts first class bill of exchange and government securities held by the commercial banks.

· Open market operations: Open market operations refer to sale and purchase of securities in the money market by the central bank.

· Cash reserve ratio and Statutory liquidity ratio: Every bank is required by law to keep a certain percentage of its total deposits in the form of reserve fund with the central bank, this certain percentage is called cash reserve ratio (CRR) and also every bank is required by law to keep a certain percentage of its total deposits in the form of reserve fund in its vaults, this certain percentage is called statutory liquidity ratio (SLR).

Qualitative Tools:

· Selective credit control: Selective credit controls are used to influence specific types of credit for particular purposes. They usually take form of changing margin requirements to control speculative activities within the economy. When there is brisk speculative activity in the economy or in particular sectors in certain commodities and prices start rising, the central bank raises the margin requirement on them.

Expansionary Monetary Policy:

When the economy is faced with recession or involuntary cyclical unemployment, which comes about due to fall in aggregate demand, the central bank intervenes to cure such a situation. Central bank takes steps to expand the money supply in the economy and or lower the rate of interest with a view to increase the aggregate demand which will help in stimulating the economy. The following three monetary policy measures are adopted as a part of an expansionary monetary policy to cure recession and to establish the equilibrium of national income at full employment level of output.

· The central bank undertakes open market operations and buys securities in the open market. Buying of securities by the central bank chiefly from commercial banks will lead to the increase in reserves of the banks. With greater reserves, commercial banks can issue more credit to the investors and businessmen for undertaking more investment. More private investment will cause aggregate demand curve to shift upward. Thus buying of securities will have an expansionary effect.

· The central bank may lower rate. At a lower bank rate, the commercial banks will be induced to borrow more from the central bank and will be able to issue more credit at the lower rate of interest to businessmen and investors. This will not only make credit cheaper but also increase the availability of credit or money supply in the economy. The expansion in credit or money supply will increase the investment demand which will tend to raise aggregate output and income.

· The central bank may reduce the cash reserve ratio (CRR) to be kept by the commercial banks. This is a more effective and direct way of expanding credit and increasing money supply in the economy by the central bank. With lower reserve requirements, a large amount of funds is released for providing loans to businessmen and investors. As a result, credit expands and investment increases in the economy which has an expansionary effect on output and employment. Statutory liquidity ratio (SLR) changes the lending capacity and therefore credit availability in the economy. To increase the lendable resources of commercial banks, central bank can lower SLR. Thus, when central bank lowers SLR, the credit availability for the private sector will increase.

Restrictive or Tight Monetary Policy:

When the economy is faced with inflation, the central bank intervenes to cure such a situation. Central bank takes steps to reduce the money supply in the economy and or higher the rate of interest with a view to decrease the aggregate demand. The following four monetary policy measures are adopted as a part of an restrictive or tight monetary policy to cure inflation and to establish the equilibrium of national income at full employment level of output.

· The central bank sells the government securities to the banks, other depository institutions and the general public through open market operations. This action will reduce the reserves with the banks and liquid funds with the general public. With less reserve with the banks, their lending capacity will be reduced. Therefore, they will have to reduce their demand deposits by refraining from giving new loans as old loans are paid back. As a result, money supply in the economy will shrink.

· The bank rate may also be raised which will discourage the banks to take loans from the central banks. This will tend to reduce the availability of credit and also raise its cost. This will lend to the reduction in investment spending and help in reducing inflationary pressures.

· The most important anti-inflationary measure is the raising of statutory cash reserve ratio (CRR). To meet the new higher reserve requirements, banks will reduce their lending. This will have a direct effect on the contraction of money supply in the economy and help in controlling demand-pull inflation. Besides CRR, SLR can also be increased through which excess reserves of the banks are mopped up resulting in contraction in credit.

· An important anti-inflationary measure is the use of qualitative credit control, namely, raising of minimum margins for obtaining loans from banks against the stocks of sensitive commodities such as foodgrains, oilseeds, cotton, sugar, vegetable oil. As a result of this measure, businessmen themselves will have to finance to a greater extent the holding of inventories of goods and will be able to get less credit from banks.

Monetary Policy: Keynesian View:

Expansionary Monetary Policy:

Problem: Recession and Unemployment

Measures:

· Central bank buys securities through open market operations.

· It reduces CRR and SLR.

· It lower bank rate.

Restrictive or Tight Monetary Policy:

Problem: Inflation

Measures:

· Central bank sells securities through open market operations.

· It raises CRR and SLR.

· It raises bank rate.

· It raises maximum margin against holding of stock of goods.

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